Albert Einstein called compound interest the eighth wonder of the world for a reason. If you’re thinking about getting your first credit card, applying for a new card, or making a big ticket purchase on the card you already have, it pays to know the difference between the advertised Annual Percentage Rate, or APR, and the Effective Annual Rate, EAR. The latter is the rate you actually pay.
Credit Card Interest Case Study
Pretend your friend buys a new video game system for $299. Let’s say the APR on his credit card is 20 percent. Twenty percent of $299 is about $59. Your friend thinks $59 is how much it should cost to hold a $299 balance on the card for one year.
Let’s see if it works out that way.
How to Calculate the Effective Annual Rate (EAR)
Typically, credit card interest is compounded daily. This means that instead of charging your friend 20 percent interest on his $299 bill one time, the card issuer (the bank) will charge him a little bit of the total interest each day (1/365, to be exact). Each day that the interest is compounded, the total for the next day’s interest payment increases.
To calculate how much interest will be owed when interest is compounded daily, you need to know the Effective Annual Rate (EAR). At 20 percent interest, each day is calculated like this:
(1+.20/365)^365 – 1
1 represents one year, .20 represents the 20 percent interest rate, and 365 represents 365 days (the number of times that interest is compounded in one year.)
On a 20 percent APR, that shakes out to about 22 percent. If the interest on your card is compounded monthly, change “365” in the equation to “12.” If you don’t know when interest is compounded, call the number on your credit card and ask.
The Total Cost on a $299 Bill
At 22 percent EAR, your friend’s $299 purchase will add about $66 dollars. That may not seem like a huge difference from the $59 he expected to spend, but if you add a couple of $35 late-payment fees, the total increases quite a bit. Plus, with math like the formula above, major purchases, such as a car repair, can yield astronomically more expensive results.
Try the useful EAR calculator.
When you shop for credit cards or consider the offers in your mailbox, keep the EAR vs. APR conversion rate in mind. Use what you know to make smart, informed decisions about how each card could affect your bottom line.